The Core of the Movie Distilled Into 10 Bullet Points

I am a firm believer that anyone who understands greed can understand what precipitated the financial crisis of 2008. The terminology erects a barrier to understanding, and the movie really helped explain all those crazy acronyms. Even so, events went by pretty fast and a few things were not made clear. As an investor I was watching the whole drama unfold pretty closely. The terms really are daunting, but at some point I realized what the people were doing with all those new-fangled investment vehicles. What they did is very simple actually. It's basically Greed Gone Wild.

Here is a summary of the main thrust of the movie:

1) The home mortgage has historically been considered one of the safest kind of loans because the collateral for the loan is land. The building on the land is also considered good collateral because it must be insured against disaster (like fire) before the loan is made.

2) Traditionally, home mortgages represented a loan from the neighborhood bank or Savings and Loan. The bank earned money on the interest paid by the homeowner as the principal was being paid off. Sometimes a bank would sell the mortgage to another bank. This usually generated a small profit for the bank and freed up the cash to make another loan.

3) In the late 70s a mailroom clerk turned vice-president at Solomon Brothers, Lewis Ranieri, got the idea to pool a large number of mortgages together and sell them as a single bond. They called it a Mortgage Backed Security, or MBS.

4) A Mortgage Backed Security is an example of a financial engineering process known as “securitization”. Securitization is simply the act of grouping together a number of assets with limited liquidity (how fast they can be bought or sold), and turning them into an investment instrument (a security or bond) that is traded daily on an open market with thousands of participants. Another term that applies to Mortgage Backed Securities is “derivative”. A derivative is a made up investment instrument that is *derived* from something real (like a home mortgage). Finally, the term “Tranche” simply refers to a section or portion of the derivative, in this case an MBS. For example you would have the AAA tranche of the bond, the BBB tranche, and so on.

5) Mortgage Backed Securities became wildly popular because they were deemed extremely safe investments. Institutions in the business of rating securities (Moody’s, Standard and Poor’s, Fitch) gave the MBSs one of four tiered investment grade ratings (AAA, AA, A, BBB). Pension and retirement funds, which are always seeking a way to get a safe return on the billions of dollars they manage, LOVED the MBS. In fact, the MBS was so beloved that there was more demand than supply.

6) The demand for Mortgage Backed Securities was so great it caused lenders and mortgage brokers to think up creative ways to make more home loans. A simple way to make more loans was to reduce lending standards. This gave birth to the subprime loan. The minimum credit score (FICO score) required to qualify for a home loan was lowered. Minimum income level was lowered. The minimum down payment was lowered. The result was a lot more mortgages were created. And thus a lot more Mortgage Backed Securities were created, satisfying the insatiable need of the market. THE IMPORTANT THING TO NOTE HERE IS THAT THE BANK MAKING THE LOAN DID NOT HAVE TO WORRY IF THE HOMEOWNER WAS GOING TO MAKE THEIR PAYMENTS ON TIME, BECAUSE THE BANK IMMEDIATELY SOLD THE MORTGAGE TO A FIRM THAT WAS POOLING THE MORTGAGES TOGETHER AS MORTGAGE BACKED SECURITIES.

This is how the term “liar loan” came into being. It got to the point where people were just making up numbers when they filled out a loan application because the information was not being verified. There was no reason to. The risk was being transferred to someone else.

7) At some point enough people were late on their mortgage payments that the average MBS containing the mortgages was under threat of having its rating lowered, thus lowering the value of the MBS. In order to cover this up the CDO was invented. The Collateralized Debt Obligation is just a fancy term for repackaging risky mortgages in such a way that the rating agencies gave them an investment grade rating. THE IMPORTANT THING TO NOTE IS THAT THE FRAUD SHOULD HAVE BEEN STOPPED HERE. THE RATING AGENCIES PROSTITUTED THEMSELVES TO INSURE THAT THEIR VERY LUCRATIVE INCOME STREAM FROM RATING ALL THE MBSs AND CDOs WOULD CONTINUE. As the character Georgia who worked for Standard & Poor’s responded when Mark Baum (Steve Carell) asked if the firm had ever refused to rate a single bond at the % of AAA requested, “If we don’t give them the ratings then they’ll got to Moody’s, right down the block.”.

8) People like Michael Burry (Christian Bale), Jared Vennett (Ryan Gosling), and team Charlie Geller & Jamie Shipley figured out how shaky the MBSs and CDOs were. Burry in particular saw an upward adjustment on the interest rate on Adjustable Mortgage Rate (ARM) loans coming. He foresaw that the resulting higher monthly premiums would cause defaults on the mortgages. Burry and the others coaxed banks into insuring the MBSs. The industry term for insuring securities is Credit Default Swap or CDS. This is not a very intuitive phrase but think of it like this: If there was a *default* then the CDS holder gets to *swap* the bad paper for cash. The banks thought that Burry and his ilk were insane to make a bet on an event that had not occurred in recent memory, but they took the money anyway (after all, they are banks).

9) Even with relaxed lending standards creating record numbers of mortgages to feed the MBS pool, the market place demanded even more of these super safe investment vehicles. Too much demand. Too little supply. So this time the problem of insufficient supply was solved by creating a CDO of a CDO. They called it a synthetic CDO. The synthetic CDO was simply a side bet on a CDO. If the CDO made money the synthetic made money.

10) Recall that Burry and the others had made their own side bets on MBSs. The side bet these guys made however wasn’t that these securities would be successful, but rather that they would fail. THE BIG SHORT. The investors in MBS, CDO and synthetic CDO made money from the interest homeowners were paying on their mortgage. Conversely the holders of Credit Default Swaps made money when the homeowners stopped making payments. The twist was that the banks that held the failed mortgage bonds were often the same banks that had to pay out on the CDS protection to insure against such losses. Ha. Ha. Ha.

Except the joke was on the American taxpayer as most of the banks got a get-out-of-bankruptcy-free card. As the whole fiasco reached a crescendo, all the financial institutions holding the failed derivatives tried to sell them off to other unsuspecting institutions (as opposed to doing the right thing and taking their losses). It was a like a game of hot potato. But someone had to end up holding the bag. At some point everyone wised up and was in a panic to buy insurance on the MBSs and CDOs they still held. That bid the price of the credit default swaps held Burry, Baum, Jamie and the others through the roof. But even the CDSs were at risk because many of the firms that were to pay out if the CDSs were triggered were busy going insolvent from subprime related losses. Before the bailout came it was looking more like musical chairs, only with no seats left for anyone in the game. Burry and the others appeared to be getting out just in time. That is why near the end of the film Vinnie was begging Mark Baum to sell his CDSs. In short order the swaps were expected to be worthless. As it happens a few firms such as Lehman Brothers, Bear Sterns, Countrywide Mortgage and some others were allowed to fail. Hundreds of others like Goldman Sachs, JP Morgan Chase, Morgan Stanley, Wells Fargo, and Bank of America were saved from bankruptcy, by you and me.

Epilogue: The twists and turns in this real life story, like so many Hollywood movies, seem to never end. At the end of the day The Big Short postulates that the banks knew all along that a taxpayer bailout was their ace-in-the-hole. And yet even after this particular movie ends the twists and turns continue. The widespread fraud that Mark Baum spoke of in the debate with the “famous bullish investor” continues. I would suggest you google the “Dodd–Frank Wall Street Reform and Consumer Protection Act”. This law, passed in response the events depicted in The Big Short, actually does exactly the opposite of what its name states. The new ace-in-the-hole the banks have the next time this happens is far scarier. Please educate yourself and take what precautions you can.